Understanding the Debt to EBITDA Ratio
No, you’re not crazy. EBITDA sounds like gibberish. And if you’ve never heard it pronounced, it goes like: ee-bit-duh. Now you can at least sound like you’re in the know, right? Despite how it sounds though, EBITDA is an acronym worth understanding. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
If this seems like a Russian nesting doll of vocabulary, hold tight. We’ll go through each term one by one and we promise by the end it won’t seem so bad.
EBITDA
Earnings
A company’s earnings are equivalent to how much money they’re making after subtracting out basic operational and overhead costs.
Interest
Companies pay interest just like we do – on loans, bonds, and other forms of debt.
Taxes
Companies also pay taxes just like individuals do. While we may be in very different tax brackets, companies are required to pay a variety of different taxes at the local, state, and federal level on their profits.
Depreciation
Assets that lose value over time are considered to be depreciating assets. Essentially it means that these assets are worth less as time goes by because of things like declining usefulness, obsolescence, wear and tear, etc. One of the most common ways we experience depreciation is through the decline in value of our vehicles. Unless your car has a cult following, your car is likely to start losing value as soon as you drive it off the lot.
Companies account for the loss in value of their assets over time, for things like machinery, vehicles, supplies, etc.
Amortization
Amortization is very similar to depreciation but applies to what are called intangible assets. What’s an intangible asset? It’s an asset that does not take physical form. Some of the most common types of intangible assets are patents, trademarks, copyrights, and other forms of intellectual property.
All of these things exist on paper, but don’t take physical form. Despite that, they can account for tremendous amounts of value for a company – think big tech companies.
What does EBITDA mean?
Now that we’ve got the vocabulary out of the way, let’s pull everything together. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Thus, you’re calculating a company’s earnings before subtracting all of those costs.
You might be thinking, EBITDA seems a lot like gross profit – and you’d be right. A company’s EBITDA and gross profit are similar, but they aren’t the same. The difference lies in what gets added to or subtracted from a company’s revenue.
Gross profit subtracts out only direct costs associated with production (and does not subtract things like general overhead). On the other hand, EBITDA takes operational income (accounting for overhead costs) and adds back in non-cash expenses like depreciation and amortization.
Here are the equations:
Gross Profit = Revenue – Cost of Goods Sold (i.e. how much it costs to sell the goods they’ve produced)
EBITDA = Operating Income + Depreciation + Amortization
EBITDA vs Gross Profit
Both EBITDA and gross profit help you calculate the earnings of a company. They simply go about it in slightly different ways. Gross profit does a better job at measuring the efficiency of a company’s production efforts. EBITDA, on the other hand, does a better job of showing the financial performance of a company. EBITDA also helps shed light on a company’s future earning potential.
Why should you care about EBITDA?
So, after all these equations and vocabulary lessons, why should you actually care about EBITDA? As we just went over, EBITDA calculates a company’s financial performance and acts as a good indicator of future earning potential. This is very beneficial information for investors, analysts, and portfolio managers as they work to determine if a company is properly valued.
What is the debt to EBITDA ratio?
Now that we have a good understanding of EBITDA, let’s talk about what the debt to EBITDA ratio is. The debt to EBITDA ratio is calculated by taking a company’s total debt and dividing it by their EBITDA.
What this calculation essentially tells you is how much cash a company has available (i.e. its cash flows) to pay back its debts. Or, if you want to think of it in another way, how much money a company has in earnings compared to debt.
How do you calculate the debt to EBITDA ratio?
Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization
For example, say a company has $6 million dollars in debt and an EBITDA of $3 million dollars. Their Debt to EBITDA ratio would be: $6 million dollars/$3 million dollars = 2. Thus, said company has $2 of debt for every $1 in earnings.
What is a good debt to EBITDA ratio?
The answer to this question comes with some limitations. The reason for this is because you can’t compare one company’s EBITDA in one industry with a second company’s EBITDA in a completely different industry. That’s partly because different industries can have vastly different levels of those intangible assets we referred to earlier.
Some industries are also much more capital intensive than others. A capital intensive industry is one that requires a lot of assets to be able to sell anything. Examples of capital intensive industries include automotive manufacturing, steel production, telecommunications…basically industries that have high fixed costs. This means that it would be more acceptable to have a greater debt to EBITDA ratio in those industries. That’s because industries which require more infrastructure and have higher fixed costs, the average level of debt is also higher.
However, as a general rule of thumb, a company with a debt to EBITDA ratio of 3 or less is seen as financially stable. In most industries, a debt to EBITDA ratio above 3 can indicate future problems paying back debt.
The bottom line
No financial ratio out there will give you everything you need or want to know about a company. So remember to take the debt to EBITDA ratio with a grain of salt. However, it’s a useful tool to help you understand how a company is performing and help you predict how they may perform in the future.
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